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Nuance Communications, Inc. (NASDAQ:NUAN)

F4Q08 Earnings Call

November 24, 2008 5:00 pm ET

Executives

Paul A. Ricci - Chairman of the Board, Chief Executive Officer

Thomas L. Beaudoin - Chief Financial Officer, Executive Vice President

Analysts

Brent Thill - Citigroup

Richard Davis - Needham & Company

Daniel Ives - Friedman, Billings, Ramsey & Co.

Jeff Van Rhee - Craig-Hallum Capital

Tom Roderick - Thomas Weisel Partners

Derek Bingham - Goldman Sachs

Shyam Patil - Raymond James

John Bright - Avondale Partners LLC

Scott Sutherland - Wedbush Morgan Securities, Inc.

Craig Nankervis - First Analysis Corp.

Mark Murphy - Piper Jaffray

Operator

Welcome to Nuance’s fourth quarter 2008 conference call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer period. Instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference call is being recorded.

With us today are the Nuance Chairman and Chief Executive Officer, Mr. Paul Ricci, and Chief Financial Officer, Mr. Tom Beaudoin. At this time I would now like to turn the conference over to Mr. Ricci.

Paul A. Ricci

Before we begin I remind that matters we discuss this morning include predictions, estimates, expectations and other forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially. You should refer to our recent SEC filings for a detailed list of risk factors.

As noted in our press release, we released along with our press release a set of prepared remarks today. Those remarks are intended to serve in place of extended formal comments on this call and we will not repeat them here.

Before taking your questions we might just recap a few points. Results for our fiscal Q4 2008 were robust as a result of strong revenue performance in a worsening environment and as a result of the tension throughout the past year to operational efficiencies.

Within revenues we were especially pleased with the performance of our health care unit which we expect to continue into this year and our mobile business which, as indicated in our prepared remarks, is likely to face greater headwinds during fiscal 2009. Although our enterprise business did not perform to expectations last quarter, we anticipate stronger performance this year as we market our expanded enterprise products and service offerings and as we see a continuing shift of our revenue growth towards our services.

As we suggested in our prepared remarks we approached guidance this year with caution. Nevertheless, in preparing our forecast we have drawn upon both the diversity and recurring composition of our revenues. We also note that the company enters this year with a suite of product and service offerings in each of our primary markets superior in breadth and depth to any previous time in our history.

We further remind investors that we remain confident enough in the attractiveness of our markets to continue making increased investments in both R&D where we will invest approximately $125 million this year and in our sales organization where we will continue to expand our sales personnel worldwide even in this difficult climate.

While we must be cautious in a time involving this degree of economic uncertainty, we do point investors to the expansion of our operating margins and cash flows during the previous two quarters and our continuing commitment to further improvements this year.

With that we’ll take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brent Thill - Citigroup.

Brent Thill - Citigroup

As it relates to your organic guidance for fiscal ’09, can you help us understand? I think you guided 13% to 26% which is a pretty wide range but what should we look for organic growth? I think this year was 16%.

Paul A. Ricci

We never provide organic growth for the forward-looking year especially in this environment. I haven’t done the organic calculation for ’09 so I don’t know.

Brent Thill - Citigroup

If you could maybe help us understand the assumptions you made in drawing that wide range of guidance? What are you assuming for ’09? Are you assuming the macro is getting worse in that environment, stable? If you could give me some assumptions, that would be helpful.

Paul A. Ricci

Just to begin with our written comments, to start we of course approached the year with a sizable amount of recurring revenues and another set of revenues which we think are highly visible that draw upon either a backlog in installations or a backlog in delivered services. That’s the first point.

In the enterprise business we assumed that the macro environment we find ourselves in now will continue, perhaps even worsen. As I said in my comments a moment ago and as we said in our written comments, we do think however that the increased pressures upon institutions to reduce costs related to customer care, at least in our historical experience, has driven people to look more aggressively at speech deployments. There is an unmistakable trend in our enterprise business towards hosted solutions rather than on-premise solutions.

But we assume that the macro environment in our large vertical markets where we sell our enterprise solutions will be very difficult.

We also assume that demand for mobile devices is going to be under pressure this year as our comments indicated and that will result in pressure on our royalty reports from our automotive and handset manufacture customers. We expect this to be a difficult year in terms of price pressure from those companies as they seek to address their own financial issues. Last year was also a fairly difficult year of price pressures from them so that may be somewhat of a continuation of a trend, but it could worsen.

On the other hand we are deploying mobile services this year that will bring growth on line and for which we have committed contracts, so we will see some growth of that. Since we can’t say in advance what the consumer reception to those services will be primarily through carriers, we have to be cautious. But we’re going to see some revenue growth from that.

Finally in health care I think we’ll see the least effect of the economic climate and we will also enjoy a relatively high benefit from the growth of our on-demand services there which are going to have growth from contracts that have already been signed and not yet brought on line.

We also will have that benefit in the enterprise business where we have on-demand contracts that have been signed but not yet brought on line.

Operator

Our next question comes from Richard Davis - Needham & Company.

Richard Davis - Needham & Company

With regard to the R&D side of your equation, where do you guys stand on internationalizing R&D in terms of how many guys are you doing in China, elsewhere and what are the prospects for that because you have been continuing investment? I was just wondering how that’s proceeding.

Paul A. Ricci

Nuance has a fairly geographically diversified R&D base already including personnel in India and China. We have been increasing our personnel particularly in India over the last year, to a lesser extent in various places in Asia. We would expect to do more of that this year. We have enjoyed in the recent months some benefit to the internationalization of our R&D team simply because of the currency shifts that have gone on. Since we have a relatively high proportion of R&D outside of the US, almost all of those sites have enjoyed some currency benefit for us.

Operator

Our next question comes from Daniel Ives - Friedman, Billings, Ramsey & Co.

Daniel Ives - Friedman, Billings, Ramsey & Co.

On the operating expenses, can you walk us through your assumptions for the year in terms of headcount and just how you’re planning for this environment in terms of cost structure and the employee count?

Paul A. Ricci

I don’t have the precise headcount number growth for 2009 on me but I can tell you that our growth in headcount is almost entirely limited to two areas. One is R&D where we feel the need to continue to fund investments in new product initiatives that we think have promise, and the second is in sales where in markets where we think that there are continuing opportunities for expansion by increasing our coverage.

I don’t have the precise numbers of those but they’re smaller than they were last year for sure and that’s reflected to some extent in the operating margin improvement that I think you can calculate in the guidance we’ve given for ’09 even at the lower end of the revenue range. Elsewhere in headcount, other than those two areas, we will have very little hiring and in fact we’ve done some reduction in recent weeks in some of those areas.

Daniel Ives - Friedman, Billings, Ramsey & Co.

Could you just walk us through cash flow assumptions for next year, just generally in terms of free cash flow generation?

Paul A. Ricci

We have not historically provided specific cash flow targets. We have said that our cash flows over an annual period should closely follow our pro forma net income. I think we reported cash flows for the year just ended of around $200 million, and I think you’ll find that is consistent with that. We would expect that to be substantially true next year.

Operator

Our next question comes from Jeff Van Rhee - Craig-Hallum Capital.

Jeff Van Rhee - Craig-Hallum Capital

On the enterprise side, can you talk to the non-hosted side particularly the issues around the partner channels? It’s been somewhat of a continuing trend where they’ve been a bit soft. Your thoughts and expectations there? And in conjunction with that do you perceive it to be share loss, deals going away, just help us understand that?

Paul A. Ricci

We had a sluggish quarter with our partners again in fourth quarter, even more so than we expected. I think that is a situation that’s not going to remedy itself quickly. There have been as I think you’re aware announcements of sales of some of our partners, restructuring of some of our partners over the last six months, and without a doubt those actions have affected the selling going on through those partners.

We began to address that problem increasingly over the last six months by broadening our own direct selling capability particularly outside of North America. We’re going to continue to do that this year under the anticipation that we’re going to see disruption from them and because more and more of our sales are going to a services solution and an on-demand solution in any case, which we tend to more directly sell to the end customer.

Jeff Van Rhee - Craig-Hallum Capital

Just to be clear, your perception is there’s no share loss at end customers?

Paul A. Ricci

No, I don’t think there’s a share loss at end customers. I don’t think there’s been any material change in that.

Jeff Van Rhee - Craig-Hallum Capital

You’ve combined some of the categories. I was wondering if you could help looking at the organic enterprise growth this quarter and the organic embedded growth this quarter? The last question is you’re throwing out tremendous cash flow here; a lot of concerns around debt in general. Your thoughts about the debt you’re carrying and potential uses of cash?

Paul A. Ricci

Let me take them in turn. With respect to the question of a debt, let me start with that one while I look for a piece of paper to answer your first question. Of course we are enjoying some benefit in the reduction in interest rates over the last couple of months and that has had a noticeable benefit in our projected net interest expense for the current year. I think we are unlikely to pay back debt soon because in these times one wants to husband one’s cash and that’s what we’re inclined to do as well. As we go later into the year we may in fact do that, but at the moment we’re realizing some significant gains in interest expense simply by the reduction you’ve seen in LIBOR over the last 30 or 45 days.

Without going into too much detail, we are using and will continue to use some interest swapping strategy to make sure that we lock in some amount of those gains.

With respect to your question on organic numbers, I’m afraid I didn’t bring the piece of paper. I’m going to give it to you and I hope that I’m going to get it right. I believe in mobile the organic growth was about 45%. I believe in enterprise it was -2%. I believe in health care it was 19% or 20%. In Dragon it was 11% or 12%. In imaging I believe it was -5%.

Jeff Van Rhee - Craig-Hallum Capital

In terms of the quarter and the progression through the quarter, guided by segment or overall with just a pretty dramatic change in the pace of the overall economy, any commentary of note intra-quarter segments that tended to end the quarter as well as they started it or others that ended particularly weak? Any intra-quarter color would be great.

Paul A. Ricci

Not so much intra-quarter changes in health care and not in Dragon, both of which were quite strong as they proceeded through the quarter. It’s clear that the enterprise business did come under increased pressure at the end of the quarter particularly as I think you would not be surprised to hear financial services deals. Also we did see some conservatism coming into the mobile handset manufacturers that had less affect obviously in the quarter.

Operator

Our next question comes from Tom Roderick - Thomas Weisel Partners.

Tom Roderick - Thomas Weisel Partners

With respect to looking at the full year guidance and reconciling that against the first quarter guidance particularly on the revenue side, it seems as though the guidance is a little bit more back-end loaded than we might have expected and than what we’ve seen in historical patterns. Are you making an assumption that the environment gets better as you go through next year or is that back-end loaded nature more a reflection of contracts that are signed and committed to that ramp throughout the year such as some of these hosted agreements and some of the SNAPin agreements?

Paul A. Ricci

I might start by saying the first half revenues in our model for 2009 are about 44% of total revenues. If one looks at the last three years, they’ve ranged between 44% and 46% for those three years. I don’t think it’s a significant difference. It’s a point or two below last year but it’s roughly in the range of the last three years.

Having said that, we are certainly not anticipating a better environment as we go out throughout the year. We are anticipating the benefit of continued growth in installations in our on-demand business both in health care, particularly in health care but also in enterprise where we have revenues that don’t really come on line for some number of months or quarters until after the contract’s been signed.

We will see revenue benefits in the out quarters from SNAPin from our Philips acquisition and from the outbound calling solution that we acquired through MultiVision some while back that continues to ramp through this year. Those are all contributors that increase revenues over the second half of the year.

Tom Roderick - Thomas Weisel Partners

In terms of the health care division, you just referenced that where it did shift to more hosted business. It seems like it’s putting a little bit of near-term pressure on the growth profile in that business. Can you just elaborate and talk about what changes are taking place particularly as you work through the integration of eScription with the classic eye chart business?

Paul A. Ricci

The revenue pressure that we cited in our formal comments was not so much related to the hosted business as it was to the fact that our on-premise products, radiology product and general clinical product in health care. We are finding customers, even some of our larger hospital customers, who express preference for a subscription pricing or a transaction-based pricing, a form of leasing in effect, rather than an upfront capital payment. As we said in the prepared comments, we benefit from that over time. It’s economically superior to us over time but it does have a different revenue stream over the course of this year.

We’ve been experiencing that in recent quarters and some of that is already built in. We’ve anticipated in looking at our growth over the course of this year that the capital constraints that we see throughout the economy are going to have that affect on hospitals as well and therefore there’s going to be an increased preference for that. That is probably in sum in the health care market for us something in the neighborhood of 2 or 3 points of growth over the course of the first half of the year. It’s not a huge factor but it’s meaningful.

Tom Roderick - Thomas Weisel Partners

With the debt markets effectively closed right now, will you look to use your own stock to make acquisitions or should we expect that 2009 will be pretty light on the acquisition front?

Paul A. Ricci

As we said previously in comments in the last several months, we do anticipate this being a year of reduced acquisition activity which is not to say no acquisition activity and we would primarily look to fund the acquisitions with cash. In order to use stock of course it would have to be a very compelling acquisition for our shareholders. I think it unlikely although it’s not impossible. But I think in general it is going to be a lighter year, yes, particularly as we’ve said previously our focus will tend to be on relatively small acquisitions that serve a very specific purpose perhaps in some geographical segment.

Operator

Our next question comes from Derek Bingham - Goldman Sachs.

Derek Bingham - Goldman Sachs

On the mix between product and services, at least in my model the product was quite a bit higher and the services was lower which was a little surprising given that eScription was coming on line and that was more services. Was there anything that you would point to in the quarter that resulted in maybe higher product and lower services mix?

Paul A. Ricci

The primary two factors that would have resulted in higher product in the fourth quarter were very robust sales of our Dragon product during the launch and revenues associated with our mobile licenses during the quarter.

Derek Bingham - Goldman Sachs

Could you give us some direction for enterprise and the health care businesses, what you’re expecting this year in terms of roughly how those break down by product, services and maintenance?

Paul A. Ricci

I can’t. We just don’t provide public guidance with that level of granularity.

Derek Bingham - Goldman Sachs

Is it shifting? Where are we seeing the biggest shifts? In both of those are we going to see meaningful step up in the product and services mix?

Paul A. Ricci

We’re going to see an ongoing shift towards services in the business generally and that will be driven first and foremost by the increase in hosted on-demand solutions in our health care business and secondarily in our enterprise business. We’re also going to see a growth of what we refer to as connected services, transactional based revenues, subscription based revenues, through carriers in our mobile business. Finally, we will see more solutions delivered with large services components and managed services in our enterprise business in large institutions.

Operator

Our next question comes from Shyam Patil - Raymond James.

Shyam Patil - Raymond James

My first question is around the operating cash flow. It seems like you’ve done a good job this year of improving the working capital accounts. When you look next year at cash flow, do you expect a similar contribution from your working capital accounts and if so, where would that improvement come from?

Paul A. Ricci

First of all I should mention that Tom Beaudoin and I are in different locations because of customer travel, but I’m going to go ahead and let Tom handle this question.

Thomas L. Beaudoin

As you’ve noticed 2008 was an excellent year for cash flow improvements. We’ve had a very strong focus on accounts receivable and overall working capital management. We would expect to continue those improvements, maybe not at the same rate but I think Paul’s previous comments around how we’re driving cash flows around operating income are consistent.

Shyam Patil - Raymond James

Are you expecting continued improvement in the receivables? It looks like when you break down the operating cash flow, about 40% or more is coming from improvements in receivables. I’m just asking if when you look at ’09, are you expecting something similar to that?

Thomas L. Beaudoin

I think we made significant progress in ’08 around DSO. We’ve also had some significant improvements in our agings. We think there are some more improvements but I don’t think at quite the same accelerated rate that we saw in ’08.

Shyam Patil - Raymond James

Around the health care business Paul, could you give us some sense as to how big the license piece is there and how big the on-demand piece is, especially as there’s somewhat of a mix shift occurring as some license deals are going on-demand?

Paul A. Ricci

No. We just don’t publish that level of granularity. I don’t think there’s any more guidance I can give you on that.

Shyam Patil - Raymond James

Is it something like a couple percentage points? Is it going to be something like a five percentage point swing for the year?

Paul A. Ricci

I’m not sure I understand your question.

Shyam Patil - Raymond James

Either the size of those two components or the potential change relative to what you might be expecting? How big that could be?

Paul A. Ricci

I believe that the hosted business is in the range of perhaps more than 40% of the total health care business this year and that has been and will continue to be a growth of some significant size. It was a very small part of the business only three years ago; a very small part. By very small I mean under 10%. So it’s a meaningful appreciation within the business. I think we’ve indicated more recently the growth rates in our hosted business substantially outpace the overall growth rate of the health care business.

Operator

Our next question comes from John Bright - Avondale Partners LLC.

John Bright - Avondale Partners LLC

Paul, let me take another slice of that apple. Earlier in your comments I think you talked about a high percentage of recurring revenues and another high percentage that are highly visible. Care to share what those percentages might be?

Paul A. Ricci

Sure. I think you should think of our recurring revenues, by which we mean revenues that we’re drawing from contracts that are long-term contracts in the hosted business where we have a continuity of revenue that spans a year or more or revenues that draw from long-term royalty bearing agreements or maintenance and support, as being in the range of 50% of revenues.

You should think of other revenues that we might characterize as being visible, which includes professional services that we’re installing from backlog that depending on the segment might run two or three quarters or installations of on-premise products in our health care business which have a backlog as well some number of quarters, as being another 25% or 30%. Those are probably reasonable approximate ranges.

John Bright - Avondale Partners LLC

So 75% of your business is either recurring or highly visible?

Paul A. Ricci

Yes.

John Bright - Avondale Partners LLC

I’ll shift to the embedded space. What assumptions have you made within your guidance looking forward regarding the price pressures for fiscal year ’09 and how significant do you expect those price pressures to be?

Paul A. Ricci

They’re meaningful. I don’t want to provide specific indications because of course we have lots of negotiations in front of us in the coming year. But they are meaningful. We saw price pressures last year and we’re simply assuming that they will be even more intense this year. And that’s factored into our revenue projections.

John Bright - Avondale Partners LLC

We’re now into November. You’ve got a month and change of this quarter under your belt. Certainly you’ve given guidance this quarter. October was a pretty difficult quarter overall, but how would you characterize how some of your businesses have performed in this period of time?

Paul A. Ricci

I was asked earlier about changes in our business in the latter half of the previous quarter and I think this quarter is a continuation of those trends. Large enterprise capital sales remain difficult. The health care business seems to be less affected by that. We are seeing pressure in the mobile business. We don’t have a lot of exposure to the consumer segments so we don’t have much to say about that. This is clearly a difficult environment though and we’ve tried to forecast cautiously as I said in light of that.

John Bright - Avondale Partners LLC

Have you seen accelerated interest in the hosted solutions?

Paul A. Ricci

I did mention that earlier and I should have re-emphasized that. You’re right. We have seen significant increased interest in hosted solutions including from customers who wouldn’t have appeared to have been candidates based on their practices in the past. I think they’re drawn to the attractiveness of not having to upfront capital investments, the relative speed at which they can achieve their cost savings, and also the avoidance of internal IT services that they would have to apply themselves to the problem.

John Bright - Avondale Partners LLC

A couple of quick questions for Tom. On the gross margins, directionally your order of magnitude I think gross margins were 69% for the fiscal year, down slightly from last fiscal year. Is that a trend? Is it just bouncing around? What should we be thinking about on the gross margin as we come into the next fiscal year?

Thomas L. Beaudoin

I think as we’ve put in the comments, we saw very good gross margins in Q4 and in the back half of the year. Some of that’s driven in Q4 by the mix. As we look out to next year we continue to see good opportunity given some of our hosted services and eScriptions that come in. Additionally we believe there’s continued opportunity in the integration and the processing and the operational improvements that we’ve been able to make around some of the acquisitions and then also as we drive those businesses. We look to continue to drive about a 50 to 100 basis point improvement in gross margins year-over-year.

John Bright - Avondale Partners LLC

Tom, what was the headcount at the end of the quarter?

Thomas L. Beaudoin

I don’t have that number right in front of me.

Paul A. Ricci

There was a question earlier and I didn’t have the paper at the moment, but it’s been handed to me so I wanted to make sure I got the numbers right for you. The organic growth numbers that were requested earlier in mobile were 45%, health care was 20%, enterprise was -3%, Dragon was 11%, and imaging was -6%.

Operator

Our next question comes from Scott Sutherland - Wedbush Morgan Securities, Inc.

Scott Sutherland - Wedbush Morgan Securities, Inc.

I want to talk on the embedded mobile side. Obviously we’ve seen the reports on cell phone manufacturers on lower device sales. Can you talk about a couple of things: One, your exposure towards the Smartphones versus the mass market phone and two, what you’re doing to further penetrate that market or gain more software per handset and how successful do you think you’re being right now?

Paul A. Ricci

If one looks at the spectrum of mobile devices out there from Smartphones down to the very lowest cost phones that tend to be sold in developing economies, our representation on those phones is proportionately higher as one goes up that ladder to the more expensive and complex phones simply because they can afford more software on them and they have a larger computing and memory footprint with which to run the software. Without overstating it, we have a proportionately higher representation in Smartphones.

There was a second part to your question and I’m sorry I’ve forgotten it.

Scott Sutherland - Wedbush Morgan Securities, Inc.

I was just wondering where are you on the penetration opportunity? I think when you first acquired VoiceSignal and others you were talking about 20% penetration of all phones and trying to get to 30% by the end of this year. Are you kind of on par with that or do you think you’re above or behind where you thought you’d be penetrating devices and how are you getting new applications on existing customer devices like speech control?

Paul A. Ricci

I think we achieved our penetration objectives for 2008 and we’re cautious about 2009 because device manufacturers are in a very conservative mood right now. Having said that we do think that the visibility of our solution on certain Smartphones in 2009 will provide a compelling reason for new Smartphones as they come out to also adopt our solutions. So I think we’re guardedly optimistic about that. I should say though that we also have an effort in place to expand our penetration in the lower end phones and the pricing is not as attractive in the lower end phones but the unit volumes are extraordinary. We are equally focused on that.

Scott Sutherland - Wedbush Morgan Securities, Inc.

One other question and a couple of quick ones for Tom. On the quarter you’re almost two months through and we’re getting to see a sequential decrease in overall revenue. Obviously Q4 was pretty decent. Did you see any one-time products or licensing deals done in Q4 that made that high or are you being cautious on a couple parts of the business in Q1 and what parts of the business are you being more cautious on near term?

Paul A. Ricci

We did have some significant deals in Q4. We have significant deals in every quarter. To some extent our Q1 estimate is based upon a view that we’re less likely to have large deals this quarter throughout the business and we also won’t enjoy the end-of-quarter deals one does with the federal government typically in September. So those won’t be in this quarter.

We’ve assumed that that component of the December quarter that one often sees which is end-of-year corporate buying is simply going to be absent. Perhaps that will be the case; perhaps it will not; but our assumption is predicated on very, very limited corporate buying in December. So that effect in addition to the end-of-fiscal year effect that we get by having our fiscal year in September contributes to the sequential change between Q4 and Q1.

Scott Sutherland - Wedbush Morgan Securities, Inc.

As a follow up to that, are you seeing any change in the pipeline of large deals or are you just being more conservative on closing that pipeline?

Paul A. Ricci

There hasn’t been a dramatic change in the pipeline of large deals. Certainly there has been some further deterioration in the financial services pipeline but I emphasize deterioration and not cessation. We have seen and we continue to see opportunities in financial services some of which as I mentioned earlier involve hosted opportunities. I think the pipeline in the second half of Q4 and today is roughly comparable.

Scott Sutherland - Wedbush Morgan Securities, Inc.

Just a couple of quick financial numbers. What was cap ex in the quarter and what percent of revenue is now international? Are you assuming any fx headwinds on the revenue for the next year’s revenue?

Thomas L. Beaudoin

Cap ex was $3.8 million in Q4. The international revenues were 27%.

Scott Sutherland - Wedbush Morgan Securities, Inc.

And what are you assuming for any fx headwinds on revenue for ’09?

Thomas L. Beaudoin

fx as Paul alluded to earlier will give us a fairly nice little benefit here from a cost standpoint. In most of the major currencies from a revenue standpoint it’s of course gone the other way. We do have some of our revenues that even in that international base that are US dollar based so that helps us quite substantially. I think from an overall operating profit benefit we will see a benefit from the movement in the currencies over the last few weeks.

Paul A. Ricci

For purposes of modeling it may be helpful to know that our primary exposure is to the Euro and I think our model internally is at $1.26 or $1.27. As Tom pointed out we see a sizable cost benefit in our full-year P&L at that ratio.

Operator

Our next question comes from Craig Nankervis - First Analysis Corp.

Craig Nankervis - First Analysis Corp.

I wanted to go back to the mobile division for a bit. It was so strong in the quarter. I’m trying to understand what was behind that strength. Was Nokia a one-time event that doesn’t continue? I also noted how SNAPin and the like, the mobile care solutions, exceeded expectations. I just wondered if you could elaborate on particulars of why you were so strong in that division?

Paul A. Ricci

I can’t speak to any one vendor. I can say that most of our contracts either involve ongoing royalty streams or periodic payments. The fourth quarter was a combination of a number of things that had been put in place throughout the year that included strong royalty reports, the initiation of royalty reports from new contracts that had been signed some while back, and the benefits of new agreements that were signed during the quarter.

Craig Nankervis - First Analysis Corp.

Where do you stand Paul with the carrier services that had been talked up a few quarters back and there was discussion about how things were in the works presumably with other carriers delivering services, I think like the Rogers Wireless and Sprint stuff? Is there an update to that activity?

Paul A. Ricci

We have contracts in place and in some cases they have been protracted in launching. Carriers move very methodically but we do have revenue streams coming on line during this year. The uptake of those of course will depend on what the reception is in the various markets where they’ve been signed and among consumers. But as I indicated several places both in our written comments and in my answers that remains a significant commitment for the company and one of our priority areas of investment because we think it is not only a source of growth this year but in years to come.

Craig Nankervis - First Analysis Corp.

On your guidance for the fiscal year, have your revenue assumptions for your acquisitions that you made this year, eScriptions, SNAPin, Philips, changed one way or the other from when you initially provided what you projected you would derive from them in FY09?

Paul A. Ricci

Largely no, but I will say that in health care because we have a lot of hosted contracts, we are able to model what the revenue growth is in an existing contract historically. There is some evidence that the growth in patient visits is declining and therefore we’ve taken into account some of that. But I think that’s a minor affect. I think the answer primarily is no.

Craig Nankervis - First Analysis Corp.

Help me understand on Dragon 10. You had such great performance in the quarter. It seems like you’re fairly optimistic for the coming fiscal year. Why is there not somewhat of a notable consumer hit to Dragon 10 as you see it?

Paul A. Ricci

First of all there is some in this quarter. We’ve assumed some in this quarter and that’s reflected in our guidance. The launch began last quarter so a fair amount of the launch effect was already exhibited in the previous quarter. The launch continues outside of the US this quarter and we have modeled some deterioration in what we expected to see in that. But I also note that our Dragon sales are increasingly targeted to specific verticals such as legal and of course medical and other deployments as well including enterprise deployments where we use Dragon in certain call center configurations for example.

Craig Nankervis - First Analysis Corp.

As you talk about your operating profile for this coming fiscal year, you talk about reduction in planned hiring, accelerating consolidations, and expense restrictions. Is there any headcount reduction envisioned from here on?

Paul A. Ricci

Nuance did a headcount reduction in the early part of this year in anticipation that the environment was going to get worse and we did a second modest round of headcount reductions in recent weeks, fairly modest, in anticipation that the environment continues to deteriorate. I don’t anticipate further headcount reductions at this point.

Operator

Our next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

Paul, what kinds of trends are you seeing from the automated directory assistance side of the business in terms of the volume of calls, the price per call or transaction, etc. in this environment?

Paul A. Ricci

I don’t have at my fingertips current information about that. We have seen ongoing growth I can tell you in the free 411 solutions out there. We’ve talked about that previously. We continue to see a fair amount of conservatism among carriers in deploying directory assistance automation. But I don’t have specific pricing information that I can inform my answer with so I can’t really say more.

Mark Murphy - Piper Jaffray

On the Philips medical acquisition, given the market share that you would have now in the US and Europe, what are you expecting from the pricing environment there in that medical transcription on-demand business and the competitive environment in those markets for the duration of FY09?

Paul A. Ricci

Philips doesn’t really address the American market so it’s not really relevant to the primary health care market that we’re in which is the United States. Nuance’s health care business today prior to Philips is in the range of 90%+ in North America and Philips’ not really relevant to that environment. We acquired Philips for its capabilities to expanding in European countries where trying to build out our solution organically was going to be prohibitively expensive. They have a very broad language portfolio of European languages in particular and they have channels established in Europe. We didn’t have a lot of overlap with the Philips business except for a couple of European countries.

So your question about pricing is not really a Philips question; it has more to do with the overall North American environment. Our primary competition in North America of course comes from the large transcription firms and we and they have been in a fairly aggressive competition for several years now that if anything has intensified over the last year.

We think pricing will continue to decline; however we think we have the highest efficiency and most cost-efficient solution. Our view is that as pricing declines we are in a position to exert greater leadership. So we welcome price competition in North America because we think it will help us take market share from the large transcription firms.

Mark Murphy - Piper Jaffray

Regarding the December quarter revenue guidance, I know that you’ve kind of addressed parts of this question but the observation being that today is November 24 so presumably I think you would have reasonably good visibility into that number for December. But the business hasn’t reported a sequentially down December quarter in a long time. I guess the presumption being that the large revenue mix is recurring subscription and then a big royalty license stream that has very strong December seasonality. Could you maybe help us dissect which revenue lines you think will be sequentially up versus down in December or just how to think about the underlying dynamic there?

Paul A. Ricci

I think in my earlier comments I’ve probably given you as much information as I can share. We clearly expect pressure in the mobile segment from royalty reports because we see reports that there has been a market drop-off in mobile device sales and automotive sales. We anticipate as I said in my earlier comments that we won’t enjoy the traditional end-of-year corporate buying that tends to go on so we’ve not modeled that. Of course just being the time it is, we’ve applied what we believe is some general prudence in estimating the other revenue lines as well which may not be particularly as specifically affected by the environment.

Mark Murphy - Piper Jaffray

As far as the mobile device side of this, I think when we’ve discussed this in the past the commentary was that that’s a game of penetration so that if there’s a slowdown in those end markets, particularly for cell phones, that it probably wouldn’t impact the business results. Are you talking about a set of devices that is profoundly broader than the cell phone market? Is that why you’re expecting some impact this time?

Paul A. Ricci

What we’ve said in the past is that the primary variable driving revenues for us in mobility was penetration as our penetration was relatively low as a proportion of overall devices. It has increased over the last year so that dominance of penetration over price or overall market shipments has diminished somewhat.

But more importantly the kind of decay that is being forecast by our customers, our partners, in their own sales is far greater than anything we’ve previously anticipated. We can’t tell you what it’s going to be. We’re just trying to be reasonable and prudent in our own guidance because we read the same reports you read and those reports tend to indicate that consumer purchases of devices has dropped considerably. So we have to model that into our expectations.

It will be offset to some extent by new license agreements. It will be offset by mobile services but as we sit here today trying to provide reasonable full-year guidance, we have to make our best estimates and on that we draw on the same information you see.

Operator

Our final question comes from Brent Thill - Citigroup.

Brent Thill - Citigroup

Paul, just on the op margin. If you assume you’re going to get to 200 basis points for ’09, you’re going to be in the high 20s. How should we still think about the long-term operating margin target? And then a follow up, in the text you mentioned a significant portion of your growth in ’09 will be weighted towards several product launches in the second half. Can you quickly remind us in terms of what you’re anticipating in that launch if you can?

Paul A. Ricci

I believe that the weighted comment was specific to the imaging business. It may not have been as clear in the text. I can’t preannounce those products but I believe it was that there are a couple of product launches in the imaging business this year. That comment, whether it was clear in the text or not, was targeted at that.

As we indicated a couple of quarters ago we felt confidence in our ability to deliver 2 points of operating margin improvement in ’08 and I think in fact we delivered 4 points. I indicated in the most recent call the fact that we had achieved I think 29% operating margins in the third quarter and of course subsequently we’ve delivered better than 30% in the fourth quarter, indicated that we were well positioned to deliver 29% this year and I think we believe that to be the case.

I think that it’s a little premature to talk about the following year but we have said previously that our objective is to deliver 2% points of operating margin improvement per year and we stated that objective a couple of years ago and we’ve been on that track for two or three years now. So I would be careful about forecasting 2010 but that is certainly going to be our objective for 2010.

Well, I think that’s the end of our questions. Again I want to thank you for joining Tom and I today and we look forward to speaking to you next quarter.

Operator

Ladies and Gentlemen, that does conclude our conference for today. We thank you for your participation and for using the AT&T Executive Teleconference service. You may now disconnect.

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Source: Nuance Communications, Inc. F4Q08 (Quarter End 9/30/08) Earnings Call Transcript
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